TFSAs grow up: Why RRSPs now have some serious competition

You’re young, sitting on a small pile of money with an eye on the housing market but don’t know what do with that cash in the interim.

It’s a scenario that the tax-free savings account almost seems made for, given it’s flexibility in terms of withdrawal while maintaining a tax advantage. Word yesterday that the government is upping the annual contribution in 2013 by $500 to $5,500 just gives young Canadians — and anybody looking for an alternative to a traditional retirement savings plan — one more reason to choose a TFSA first.

We are seeing more and more buyers using the TFSAs as a saving vehicle as they build up their down payment

TFSAs have grown up since they were first introduced in 2009 and by next year Canadians will have had the opportunity to contribute $25,500 to their plans, enough cash that the accounts can be used for some serious planning.

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No one is suggesting the RRSP is about to disappear, there will always be an advantage to reducing taxable income if you are in a high bracket. But for low income Canadians in the bottom tax brackets, and people who need access to their cash in the short-term, you can’t go wrong with a TFSA.

“We are seeing more and more buyers using the TFSAs as a saving vehicle as they build up their down payment,” said Farhaneh Haque, director of mortgage advice at TD Canada Trust.

Up until now the Home Buyers’ Plan — it lets individuals take $25,000 out of their RRSP to buy their first home as long as it is repaid over 15 years — had been the vehicle of choice for saving for a property.

Ms. Haque notes there is still a lot of money out there in RRSPs so the preference for home ownership will remain with the RRSP for the short-term but in the long run the TFSA has a major advantage because you are not tied to the payback period.

We are seeing more and more buyers using the TFSAs as a saving vehicle as they build up their down payment

The increase is consistent with a pledge from the Harper government that the $5,000 annual contribution limit would be indexed to inflation in $500 increments. Next year is the first year to be impacted.

“Our government remains committed to our low-tax plan for jobs and growth and we are very pleased to offer Canadians ways to save on taxes and keep more of their hard-earned money,” said Ted Menzies, minister of state (finance).

“TFSAs have become an exceedingly valuable savings tool for so many Canadians.”

Ottawa says 8.2 million Canadians have opened an account and roughly 2.5 million Canadians contributed the maximum amount in 2011.

Like the registered retirement savings plan, money accrues inside the TFSA with no tax. TFSA contributions do not reduce taxable income but unlike RRSPs, withdrawals are not taxed.

A person who started a TFSA at age 18 could accumulate an unlimited amount by the time they retire, all of it accumulating interest without taxation, depending on the type of return they get on the investments held within it. Money can invested in variety of products like securities and mutual funds and unused TFSA contribution room can be carried forward and accumulate for future years.

While funds can be withdrawn tax-free at any time for any purpose you can re-contribute withdrawn amounts in the same year only if you have unused TFSA contribution room. Otherwise, you have to wait until the following year.

TFSAs and withdrawals do not affect eligibility for federal income-tested benefits and credits. Contributions to a spouse’s or common-law partner’s TFSA are also allowed.

Mike Henry, senior vice-president and head of retail payments, deposits and lending at Bank of Nova Scotia, said while only half of his bank’s customers have opened a TFSA, there’s been a marked difference in investing styles as the program has grown.

“When they were introduced, they were used as a savings vehicle and a savings vehicle only,” said Mr. Henry. “Increasingly, we are seeing people introduce investments with a a more long-term nature.”

Ted Rechtshaffen, a certified financial planner and president of TriDelta Financial, said the increase in the TFSA limit could be good news for low income Canadians with the caveat that they’d need to have the actual cash to make a contribution.

“If you are like a 20% tax rate don’t put money in your RRSP because there is a good chance you could be drawing at a higher tax rate down the line,” said Mr. Rechtshaffen.

He’s not knocking the RRSP for mid to high income clients, noting chances are you are not going to pay tax at a higher rate when you withdraw the money than the tax you avoided by putting the money in the account in the first place.

“The RRSP is still better for many people in many cases unless the government raises the top bracket [in the future] meaningfully,” says the certified financial planner.

His long-term goal is to get as much client money into a TFSA as he can. “My goal as a financial planner would be to have 100% of someone’s liquid assets in a TFSA by the time they go,” said Mr. Rechtshaffen.